New York - Moody's confirmed the Caa1 rating on Rally's Hamburgers Inc.'s $58 million senior notes due 2000, and changed the rating outlook to positive from stable.
The rating action was prompted by the steady improvement in the company's operating performance over the last several quarters.
The ratings reflect Rally's high financial leverage, the intense competition in the fast food segment of the restaurant industry, the ongoing turnaround in the company's operations, the relatively low returns on sales and invested capital, and our expectation that asset write-downs over time are likely if returns do not improve.
The company's capacity to fund its operations is adequate, but near term liquidity is strained by the upcoming maturity of the senior notes which is only 25 months away and bondholder protection measures remain tight.
However, the rating recognizes that the company has made good progress in improving operating performance over the last several quarters, the benefits of the management services agreement with Checkers Drive-In Restaurants Inc., and the ongoing strategic repositioning that is trying to move toward value oriented taste/ quality promotions with less emphasis on price.
The positive rating outlook recognizes that debt protection measures should strengthen if the company is able to continue the turnaround.
The improving trend in comparable store sales to date is encouraging, and the company has made good progress containing costs. Upward rating movement could occur in the near term if the company is able to maintain a positive sales trend and improve its operating margins.
At current levels, debt leverage is very high (5.65 times trailing EBITDA), and we believe that there is little enterprise value cushion below the senior notes.
We believe that modest sales improvements and continued cost containment initiatives could enable the company to service interest and normalized capital investment through operating cash flow, supporting a higher valuation and implying an increased equity cushion.
But upward rating movement will depend on the sustainability of the company's position in this intensely competitive segment of the restaurant industry and its ability to increase operating profit and cash flow.
The competition in the hamburger segment of the fast food industry is intense, where promotional pricing by the leading national chains can dramatically alter the competitive landscape.
Consumers are offered a wide variety of alternatives in the fast food segment and competition for consumers' interest focuses on price, convenience, food quality, and entertainment based promotions.
Rally's is currently testing indoor dining facilities in certain markets and considering other initiatives to try to build a breakfast day-part.
Both of these initiatives attempt to broaden its appeal and increase customer traffic.
The turnaround at Rally's has been underway for several quarters, but the company is showing progress.
Rally's eliminated its deep discounting programs in the second and third quarters of 1996 (annual comparable store sales had been negative since 1994 and the company's market position continued to slide even with its aggressive promotional programs).
This change in positioning contributed to the steep decline in the company's sales in 1997 (comparable unit sales declined 9.2%). However, the negative trend did improve throughout the year and the company achieved positive comparable store sales (1.6%) in the March 1998 quarter.
Even with the steep decline in sales management's cost containment programs enabled the company to maintain a positive operating margin (EBIT 3.3% of sales in the twelve months ended March 1998).
Although the company made good progress reducing operating expenses in 1997 (restaurant cost of sales and operating expenses declined from 79.8% of restaurant sales to 75.3%) operating expenses have increased in the most recent period as the company increased labor expenses in the first quarter.
As a result the EBIT margin in the March quarter declined from 3% to 1.8%.
We expect that the company's operating margin will benefit from the management services agreement with its affiliate Checkers Drive-In Restaurants Inc.
But with advertising spending expected to increase, the company will need to increase sales and leverage its fixed expenses to improve its operating margin.
Rally's Hamburgers Inc., headquartered in Clearwater, Florida, operates 229 and franchises 248 double drive-thru hamburger restaurants in the Midwestern United States.
Meat Industry Insights News Service
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